Select articles by Paul Brodsky of Kopernik Global Investors. Paul Brodsky joined Kopernik Global Investors in August 2013, and serves as a Co-Portfolio manager of the Global Unconstrained Fund. From 2006 to 2013, he served as a co-managing member of QB Asset Management Company LLC (QBAMCO), which he co-founded with Lee Quaintance. While at QBAMCO, Paul was a long/short equity portfolio manager responsible for industry-related and macroeconomic analysis, as well as for writing the firm’s comprehensive investor letters. He was also responsible for overseeing all internal QBAMCO administration and operations, and for overseeing the firm’s external service providers for QBAMCO’s US and Cayman investment funds. Through 2006, Paul was the head of investments and operations for Spyglass Capital Trading Company, a firm he founded in 1996, which managed fixed-income arbitrage funds. Before entering asset management in 1996, Paul worked on Wall Street for 14 years for firms including Kidder Peabody, Drexel Burnham, and Piper Jaffray. Paul earned his multi-disciplinary Bachelor of Arts from University of Pennsylvania.

• Central bank easing and asset purchases to date have only tempered the rate of asset price declines

• Current adversity among European banks directly impacts global commerce and finance

*Bank balance sheets can deleverage either via nominal write-downs of assets, (leading to outright failure/insolvency as tangible equity is extinguished), or through nominal increases in system reserves via base money inflation (provided by central banks as they expand their own balance sheets)

2) Governments and private parties are heavily-indebted and this indebtedness is growing exponentially

• In the aggregate, the public and private sectors have “borrowed money into existence” for decades, as fractionally-reserved banks have created unreserved deposits and extended unreserved credit

• In the net, private sector borrowing has stagnated and is prone to contraction

• In response, public sector borrowings have been increased measurably to fill this gap

o Public sector debts and deficits are increasing

o The global economy is rapidly approaching the point where neither the public sector nor the private sector can service debts to the degree required to maintain asset prices, which, in turn, removes incentives to borrow further

• Over-priced assets have led to capital over-investment in many industries/projects

o Unsupportable by labor inputs or unaffordable at current wage levels

• Most developed economies have morphed into financial economies, which over time have become fragilely dependent on net imports to sustain living standards

• The current propensity of both public and private sectors to channel ever more income towards debt service is threatening the debt-for-debt feedback loop that has maintained the appearance of stability since 2008

o European sovereign issues

o global real estate setbacks

o declining public participation in equity and other leveraged asset markets

The Expedient Solution: Policy-Administered Asset Monetization

1) Re-monetize gold as the asset against which newly-created central bank liabilities (base money) are created

The Consequences (Pros & Cons)

• Asset monetization is the least painful and most politically expedient option to reverse current conditions in which global bank deposit liabilities are many multiples of reserves (a classic precondition for bank runs)

• As nominal bank reserves grow, the illusion of returning strength to bank balance sheets would be perpetuated

• The propensity for privileged speculators to place their “risk-on” bets would likely increase

3) Public and private sector debts from the prior extension of unreserved bank credit would, at the margin, be paid down with the base money creation stemming from central bank asset purchases

• Public debts in particular could be paid down in the event fiscal agents were to sell official gold holdings to their respective central bank (central bank purchases of gold then would be, in the net, debt-extinguishing and thus, deleveraging)

4) Wages and consumables pricing would rise in asset-price terms, which would arrest and begin to reverse the political consequences of several decades of wealth and income redistribution to the top “1%”

• An easy political posture to take for those who choose to promote it

5) Asset prices would decline relative to current and future expectations of consumption expenses which, in turn, would lead to lower living standards than currently anticipated by those asset holders

• A necessary evil; however, the loss of future purchasing power as assets are sold to fund future consumption is already “baked in the cake”

• This loss of perceived value can either be crystallized and recognized today so the real economy can begin to rebalance and establish a foundation for growth, or, in the alternative, be suspended — a slow and time-consuming “death by a thousand cuts” malaise (e.g. Japan’s lost decade[s])

• Would promote debt pay-downs at par, which better ensures banking system solvency

• Would raise wages relative to debt, a powerful political palliative

7) Banks, being agnostic to measures of consumer-type price inflation, would most likely see the nominal pricing of their current pool of assets rise, which would eventually restore their solvency because the nominal valuations of their liabilities are generally fixed

• The value of the currency unit is a common denominator to both sides of bank’s balance sheet

o Real losses/gains on one side of the balance sheet are simultaneously and proportionately offset with real losses/gains on the other side

• However, this would not hold for nominal losses (insolvency would result if a bank were to go into a negative equity position should the variable nominal valuation of its assets decline as the nominal valuation of its liabilities remains constant)

8) Deleveraged government balance sheets would have less impact on private asset values and marketplace pricing

• The political dimension could review and renew optimal levels of participation and capital market intervention

9) No overall meaningful impact on the general price level (but, as implied above, there would likely be a migration f value, in real terms, from leveraged assets to unleveraged goods, services and assets)

Conclusion

Asset monetization (and in, particular, gold monetization) would solve many more problems than it would create. The negatives would merely recognize the balance sheet damage already done and beginning to be manifest (first, in the private sector and now, increasingly in the public sector).

Mechanically, policy-administered asset monetization would be quite simple. Using the US as an example, the Fed would purchase Treasury’s gold at a large and specified premium to its current spot valuation. The higher the price, the more base money would be created and the more public debt would be extinguished. An eight-to-tenfold increase in the gold price via this mechanism would fully-reserve all existing US dollar-denominated bank deposits (a full deleveraging of the banking system). An appropriate multiple of today’s spot price could fully-extinguish the public debt if desired.

In terms of the relative price spectrum, a speculative 50% increase in the US median home price would be most-welcomed to the US banking system (and certainly to mortgage holders). Clearly, such an operation would be a subsidy to leveraged asset holders and banks. Would this be another form of perpetuating moral hazard? Superficially, it would be easy to conclude so; however, we think this conclusion would be incomplete. Such a “subsidy” is already embedded and institutionalized in the system. The key distinction would be that the system will have been reset to promote fairness and efficiency going forward. Given today’s circumstances, that should be a universal, non-partisan goal.

Rolling unfunded debts and debating in the political sphere over the merits and risks of unfunded growth or policy-administered national austerity programs is a futile endeavor. The math suggests strongly neither can work. We are convinced policy-administered asset monetization would stop the global financial system from seizing, restore sorely needed economic balance, and reset commercial incentives so that real growth can once again gain traction.

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Select articles by Paul Brodsky of Kopernik Global Investors. Paul Brodsky joined Kopernik Global Investors in August 2013, and serves as a Co-Portfolio manager of the Global Unconstrained Fund. From 2006 to 2013, he served as a co-managing member of QB Asset Management Company LLC (QBAMCO), which he co-founded with Lee Quaintance. While at QBAMCO, Paul was a long/short equity portfolio manager responsible for industry-related and macroeconomic analysis, as well as for writing the firm’s comprehensive investor letters. He was also responsible for overseeing all internal QBAMCO administration and operations, and for overseeing the firm’s external service providers for QBAMCO’s US and Cayman investment funds. Through 2006, Paul was the head of investments and operations for Spyglass Capital Trading Company, a firm he founded in 1996, which managed fixed-income arbitrage funds. Before entering asset management in 1996, Paul worked on Wall Street for 14 years for firms including Kidder Peabody, Drexel Burnham, and Piper Jaffray. Paul earned his multi-disciplinary Bachelor of Arts from University of Pennsylvania.